Bullish Sentiment Continues But Leading Indicators Are Signaling A Top

 |  Includes: DIA, FXI, GLD, IEV, OIL, QQQ, SPY
by: Joseph Stuber

The question is not "if the market breaks"; the question is "when the market breaks". We all know the market is going to correct some day. On the other hand "top picking" is a treacherous pursuit. I have been amazed at the way the stock market has withstood an onslaught of negativity - all on the assumption that the Federal Reserve is guaranteeing a bull market, PERIOD.

Don't believe it. This market is going to correct. The question is "when" and "by how much". We will discuss the "when" first. In the last few days we have seen action in some markets that suggest we are getting close. The transportation stocks are a reasonably reliable front runner to a major market move and we need to look at that sector to see what, if anything, it is telling us.

What are the transports telling us?

The chart below started to diverge from the broader market around July 1st. In the last 4 days the divergence has been more dramatic. The chart below compares IYT (the Dow Transportation ETF) and SPY (the S&P 500 ETF). This chart goes back to September 2010. The two ETFs are reasonably well correlated until July 1st but the divergence is particularly pronounced in the last few trading sessions.

S&P 500 ETF and Dow Jones Transportation ETF (click to enlarge images):

Click to enlarge

At the close last night, Norfolk Southern (NYSE:NSC) reported that they expect substantially reduced earnings for the 3rd quarter based on a drop in coal shipments and lower fuel surcharge revenues. The railroad said that coal and merchandise shipments will reduce revenue for the quarter by $120 million over the same quarter last year. The stock was 5.6% lower in early after hours trading.

Union Pacific (NYSE:UNP) is off 2.25% in after hours as well. FedEx (NYSE:FDX) also reported disappointing earnings and lowered forward guidance. FedEx stock has come off 4.4% from its recent high in the last week.

Transportation stocks are good leading indicators for the broader market for obvious reasons - reduced shipments indicate reduced consumption which indicates reduced GDP. Transportation stocks haven't bought into the QE euphoria that has made the broader market absolutely giddy with raised expectations. However, in the last few trading sessions transports have actually moved in a proportionally inverse direction relative to the broader market.

Crude oil does not buy into inflation hype:

Another signal that something's up is the sharp sell off in crude in the last few days. Rumors abound on how this could happen as if the Bernanke inflation guarantee should prevent markets from pricing in reality. How could crude be off 9% in 3 days with the Fed's guarantee of inflation for a long time to come? Apparently there are some traders out there thinking that QE3 will turn out to be a bust, just like 1 and 2 were.

Forbes Agustino Fontevecchia explained it quite adequately:

Now that traders got their QE cool aid, fundamentals seem to be taking center stage again, helping to push prices down.

The fundamentals are really quite simple: Supply exceeds demand. Of course that should not matter with all this money the Fed's printing - right? All assets are supposed to go up.

Gold should be soaring:

Gold had a nice run up in anticipation of QE3 and spiked $39 after the Fed announcement last Thursday, closing at $1772.10. It has been virtually flat for the last 5 days, closing yesterday at $1771.70.

Is it just a momentary pause before moving on to $2000? Or maybe it's just that the QE life cycle is getting shorter. QE1 was announced in November 2008 and the market peaked in April 2010 before selling off - a 17 month life cycle. QE2 was then announced in November 2010 and the market peaked in May 2011 - a 6 month life cycle.

Are we at the top? All indications suggest we are getting very close. There have been a lot of signs for those willing to look. We have gone nowhere since the spike last Thursday - even the stock market has failed to follow through. The S&P 500 is within a dollar or two of its close on Wednesday. There should have been a least a little upside follow through somewhere. We are a full week now since the Fed announced their long term inflation goals and nobody seems willing to bid the markets higher.

How far will we pull back?

There's no volume and no interest on the buy side, so we wait for now. At some point it will begin to sink in that this is an overbought market. A few traders are going to realize that maybe it's time to take a little profit off the table. And then a few more and the bear begins to feed on itself, just like the bull did.

Markets move and despite opinion to the contrary this one will move as well. We are not going to go horizontal at these price levels until Bernanke announces QE4. And bear markets move a lot faster than bull markets.

We've put on over 20% year to date. The question we have to ask is whether QE3 work. If not, and there is no reason to think it will actually work, we should ask ourselves where we are today compared to where we were after the sell-off in 2009.

Well, our banks are in a lot better shape. They have deleveraged and recapitalized and paid the TARP money back. No systemic risk of bank failure today that we know of. That is a positive.

We've made major headway on the housing crisis issue and recent data suggests that things are improving in that area. Many say we have hit bottom and we are on our way back up. That may well be true and that is a positive.

Unemployment numbers, even using the broader U6 number, are slightly improved since 2009. That is not a huge plus as the number is still close to 16% using the U6 figure. Still, even though we haven't made any real progress we are not any worse either.

That sums up the positives. Now to the negatives. We are stuck in a liquidity trap where businesses and consumers are just not spending. People are still scared and they are hoarding cash where they can and curbing spending - not conducive to an economic recovery.

As to the banks, they are not lending. The Fed's actions have flattened the yield curve to a point where the reward for taking lending risks just does not exist. Since the Fed has indicated with their forward guidance that this situation will continue for several years, the prospects of bank lending increasing are not good and that does not bode well for an economic recovery.

Inflation is also not responding to Fed efforts. That probably comes as a surprise to many but it is still true. Inflation has fallen for 4 straight quarters now. Not good for economic recovery either. Despite the fact that most people don't see inflation as a positive from a Keynesian point of view it is a necessary component of a successful economic recovery.

Our debt to GDP ratio has soared through excessive entitlement payments that have back stopped the unemployed for the last 4 years allowing corporations to record profits. Actual corporate profits have been exceptional. Massive lay-offs and other cost cutting measures combined with low carrying cost on debt has been a short term boon for business but it has left the taxpayer in a huge hole.

Credit downgrades are coming unless Congress takes action to reduce deficit spending and they will do so. Both sides are aware of the problem and resolved to deal with it. The problem is that means cutting back on entitlements and increasing taxes - both moves resulting in less spendable money and a guaranteed reduction in GDP.

The federal government has managed to create a back-door corporate bailout by issuing bonds to fund the needs of the unemployed who have spent that money with America's corporations. The result is the money borrowed by the tax payers to assist the unemployed has resulted in a huge build up of cash in American company's bank accounts.

The corporate windfall looks to be over no matter who wins the election. Deficit spending has to be dealt with and it will be. The Congressional Budget Office report indicates that they think that will put us back in recession by the first half of 2013. There is no pleasant outcome on this issue, no matter what the politicians tell us.

Our major companies will be fine as their coffers are full of cash thanks to the benevolent assistance of our politicians who have managed to create a wealth transfer to these company's through massive entitlement payments thereby allowing the unemployed to spend like they had jobs. Notwithstanding their fat bank accounts, the prospects of this windfall continuing are nil.

That's enough said about the negatives on the home front. We will now move on to Europe - a major trading partner. They are in a recession and fighting for their life. Austerity measures are being put in place as conditions for bailouts. More reduced spending and contracting GDP and therefore shrinking corporate profits is the certain result of these austerity moves.

China, on the other hand, is a big question mark. Hard landing or soft landing was the question a while back. As a major exporter it is not likely that things will bode well for China if Europe and the U.S. are not buying as much. It turns out to be a kind of global problem.

So on to the musical chairs game of currency devaluing. The big question here is whether every major economy will move to devalue. The answer is "probably", but since currencies are valued relative to other currencies the game of musical chairs we continue to play will result in leaving us in the same place we were at the start as each county responds to another countries devaluation with their own devaluation. Additionally these monetary expansion initiatives are not working anyway as money is being hoarded, not spent and therefore of no benefit to the economic growth of the various countries engaging in this ludicrous process.

There are a few positives for the U.S. but a lot of negatives. There is little hope of the U.S. avoiding a recession in the first half of 2013. So, as the market enters into a correction phase how far will it fall?

We've been in a long term trading range since 2000 with the low end around 800 for the S&P and the high end around 1500 - about where we are at the present. A look at the chart below makes one wonder if maybe we are not getting ready to put in the right shoulder on a major inverted head and shoulders pattern.

S&P 500:

Click to enlarge

It's going to take a long time to get out of the mess we have created with decades of excess. I am sure we will get it done but there's a lot more deleveraging to accomplish before we do. There are a few more things that will need to happen as well. That could happen as soon as January 2014 if Mitt Romney wins the presidency. Romney has assured us he will remove Bernanke and attack the deficit and the debt and I believe he will do that if he wins. Coincidentally Obama's poll ratings have correlated nicely with the moves in the stock market. Could it be that we will sell off going into the end of the year and bring Obama's lead in the poll back down.

They say history repeats itself and maybe it will. This election looks a lot like the situation we were in with the Carter/Reagan election. We had been in an extended period of stagflation prior to the election and Reagan and Volcker raised interest rates to 20% overnight. It was a rapid and painful period that broke a lot of people but once it was over it was over and we started a period of extended growth and prosperity that lasted for 20 years.

I don't have a crystal ball but it sure seems to me that just such a scenario could materialize. If this scenario does develop we will put in a low on this pull back around 850 to 900 on the S&P - the right shoulder of a massive inverted head and shoulders pattern that should finally break us out of the 12 year trading range we have been in by the end of Romney's first term.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I don't own any stocks mentioned in this article but I am short a number of tech stocks and crude oil.